The Conversion to International Standards

Even Under One Standard, Issues Will Remain

The evolution of accounting standards, beginning with Luca Pacioli’s creation of double-entry accounting, has always been a dry subject. But with events such as the Wall Street bailout, Enron and Sarbanes-Oxley, accounting standards have been a popular topic in the business press.

A recent development that sparked controversy was the Securities and Exchange Commission’s release of a proposed road map for the Financial Accounting Standards Board to adopt International Financial Reporting Standards by 2014. The concept seems straightforward — one set of standards for all users instead of a separate set for each country. But let’s take a look at the major issues.

Rules Versus Principles

Generally accepted accounting principles, or GAAP, in the United States involves many rules — some flexible, some not. Many of the IFRS principles were written by starting with the U.S. standards and stripping away the rules. As a result, IFRS requires about 2,500 pages, compared with 25,000 pages for current U.S. standards.

Some of those who oppose adoption believe IFRS principles are naïve, while those who promote change believe the hard and fast rules of GAAP stifle entrepreneurship and make the task of accounting more difficult. The real question isn’t about rules or principles, but rather about how to maintain a consistent set of accounting standards that provide the reader of financial statements with a reliable, objective and conservative picture of the company.

On the surface IFRS appears to be what investors want: a single set of standards that apply to any comp-any based anywhere in the world. But much of the discussion still centers on “rules” or “principles.” IFRS assumes there’s a consistent level of professionalism and conservatism throughout the world. GAAP makes the same assumption, but the rules are from lessons learned.

A simple review of recent business headlines is enough to demonstrate that greed sometimes trumps conservatism, professionalism and oversight. All three qualities were thought to be in place when Enron collapsed and when the derivatives accounting scandal at Freddie Mac emerged. More recently, similar issues have gained worldwide notice, including accusations of tax shelter abuses by Ernst & Young partners and of accounting flaws at AIG that ousted CEO Hank Greenberg after 40 years.

Notice that most of these surprises occurred after the 2002 passage of the Sarbanes-Oxley Act, which calls for all SEC-registered companies to document their accounting controls. In the United States, the federal government requires companies to document their compliance with Sarbanes-Oxley; have a registered, independent accounting firm audit the books; and file the financial records with the SEC.

These steps are meant to promote a reliable, objective and conservative picture of the company. Decide for yourself, but it seems to me that even the strongest rules and controls won’t deter those who are resolved to push the boundaries.

Another consideration is the composition, funding and technical strength of the body setting the standards. The Financial Accounting Standards Board is funded by donations to a separate foundation. FASB members represent business, auditing, academia and investors, so a majority will typify a balanced view of the independent members. Except for the SEC, which controls U.S. accounting standards, the ability to influence or the FASB is limited. This allows the board to issue accounting standards that favor the reader of financial statements.

The FASB also is supported by a technical research staff that includes professionals, fellowship positions from academia, audit firms and the SEC. The group as a whole has the largest concentration of accounting minds in the world.

In many cases, IFRS principles were written by starting with the current FASB rules and then removing the so-called bright lines — inflexible, specific standards — designed to limit abuse of the standards. Many Inter-national Accounting Standards Board members have good credentials for the job, as many are former FASB members. But the research staff, independent funding mechanism and other administrative structures that built the FASB don’t exist to support the IASB.

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Differences in Stock Option Expensing

One example of how IFRS differs from GAAP relates to stock option expensing. Many companies grant options that vest in equal amounts over several years, and they’re expensed in a straight-line method. IFRS requires that each option is expensed gradually during the period between the date the option is granted and the date the option vests. This is called graded vesting. Although the amount of expense is the same, graded vesting recognizes this expense much earlier.

For example, suppose a company grants 900 options that vest one-third each year over the next three years, with the options valued at $12.50 each. The table on this page shows the differences in expense between U.S. GAAP and IFRS, even though the vesting occurs at the same time.

The question here is when to expense the options. Do you expense them in a simple, straight-line method — one-third each year — or do you follow the conceptual principle to expense each option over the time it takes to vest that option? Notice that under the straight-line method, the first-year expense is higher under the graded-vesting required by IFRS by $3,113, or 83 percent.

Effect on Global Stock Markets

Ideally, a single set of standards would provide additional transparency for investors. Buyers and sellers of stocks around the world would understand a single set of standards and apply that information to their trades. Merger activities among global companies headquartered in different parts of the world would increase as ubiquitous financial information follows IFRS.

That’s the ideal, but in practice there are different versions of IFRS. Many countries that have adopted IFRS, especially those in Eastern Europe, previously relied on their tax code to provide a set of standards. Although that may work toward social and fiscal goals, it ties politics directly to the accounting standards.

That’s not always bad; the SEC does have the power to veto any FASB standards. But the social contract between business and government differs from nation to nation. As a result, countries may develop IFRS-like accounting standards, or refer to the standards as IFRS, but they’re embedded in the country’s tax code and controlled by the government. Other nations will simply refer to the standards as IFRS yet adopt something different.

This creates an environment in which each country may have its own nuance, implementation and enforcement of IFRS standards. This eliminates comparability and leaves the reader of financial statements in the same place they are today — with multiple standards. Most likely, the markets ignore any change in accounting standards, unless it causes confusion.

With a single, worldwide set of IFRS standards, however, politics will raise issues with the process and the standards. This recently occurred when the IASB was forced to change the IFRS standard after strong Euro-pean pressure against the fair value standard. Unlike the relationship between the FASB and the SEC, the European Commission can only decide which portions of IFRS to ignore. The recent standoff led the IASB to change the standard, which damaged its credibility.

Enforcement of Accounting StandardsThe audit profession has the challenge of interpreting accounting standards in light of the client’s business and of providing an opinion as to whether the financial statements comply with the standard. They traditionally agree or suggest changes for the methods used by audit clients.

With IFRS this all seems simple, but will the interpretation remain consistent from auditor to auditor? Audit firms strive to maintain internal consistency by reviewing work papers and rotating audit staff, so the answer is yes.

But consistency from audit firm to audit firm and from country to country is a concern. In the United States, consistency from audit firm to audit firm is enforced by the Sarbanes- Oxley Act and the Public Company Oversight Accounting Board. This enforcement mechanism doesn’t exist under IFRS; there’s no United Nations for accounting standards.

In the United States, the SEC is the ultimate arbitrator of accounting standards. Although the FASB does establish standards, the SEC has a veto and uses it when it sees fit. The SEC also provides interpretations of accounting standards when it feels the FASB hasn’t been clear.

The commission recently pro-vided a unique example of how it will control accounting standards by issuing an exception. With the bailout bill for the financial industry, the U.S. Treasury took an equity position in several companies. But under GAAP, this investment is considered debt, not equity. So to avoid there being an adverse perception of the investment, the SEC, followed by the acquiescence of the FASB, provided an interpretation that in this instance, the rule would be ignored and that these invest-ments by the government are equity.

The Big Winners: Accountants

The Big Four accounting firms favor replacing GAAP with IFRS. But they don’t have a clear reason for doing so other than being able to raise fees. After the audit failures of Enron, WorldCom and Global Crossing, the audit firms received larger fees as the focus moved to audit quality and the passage of Sarbanes-Oxley. With Sarbanes-Oxley requirements added to audit requirements, billable hours increased dramatically as companies adjusted to the change.

Accounting firms also billed companies to help retrain staff from the lowest clerk to the CFO. These same events will occur when IFRS replaces current standards.

Other Issues

The effect on private companies is uncertain. Since they’re not regulated by the SEC, do they need to change? Does this mean the FASB needs to continue? Many private companies will still need to provide audited statements to banks and owners, but they’ll have little interest in converting to IFRS. The problem is that accounting firms won’t maintain two sets of audit teams to audit two sets of standards without higher compensation.

Another area is education. A completely different curriculum will be needed in all colleges to train the next set of accountants. Curriculum, textbooks and case studies will take time to prepare, and the faculty will need to know the material. A new CPA exam will be required to match IFRS as well.

Changing the standards changes everything. The devil is in the details. The SEC made a bold move in setting a timeline for the adoption of IFRS. The many disagreements may well be resolved by the time 2014 arrives. But this subject will be hotly debated for years to come.

BetterInvesting member and Iowa resident Mark Eckman, CPA, is a manager in the health care and benefits areas at Rockwell Collins.